The Knowledge ProblemCommentary on Economics, Information and Human Action

Monday, June 30, 2003

Here's a Washington Post article summarizing the National Petroleum Council summit on Thursday. The economics are pretty simple, and the statements coming out of the summit are in accordance with the economics: conservation in the short run, increased supply alternatives in the long run in keeping with the long lead times in exploration and in building liquefied natural gas terminals for LNG imports.

I would like to hear a more forceful, principled statement that retail competition and active demand are the best ways to encourage conservation. Much more effective than pleas to change your thermostat etc.

This Rigzone article (originally from Oil & Gas Advisory) highlights the demand side potential for conservation. It does so in a way and with a language that is much more within the traditional regulated context, talking about DSM programs (that's demand side management) at utilities. Such a perspective reflects risk aversion and wanting to take baby steps toward meaningful two-sided retail markets. My take is more radical; why continue to discuss programs? Why not simply free utilities, gas and electric, to offer the contracts with the features that their customers want? If we're smart enough to figure out what cell phone contracts we want, we're smart enough to choose gas and electric contracts.

KATHERINE HEPBURN RIP: A suite of New York Times articles in homage to the woman who typified living with wit, energy, verve, grace and elegance. On the NYT site there's an ad for an audio slide show that calls her "a role model for 60 years," and I certainly agree. I recently rewatched The Philadelphia Story, which I love. Although as the confessed lover of period drama that I am, I must put in a good word for The Lion in Winter.

Price increases transmit valuable information to consumers that enables them to decide when it is worth it to them to conserve. Price increases serve as the most effective inducement to conservation, because they signal to consumers large and small that the relative value of natural gas has increased. They also tell suppliers when it is worth bringing more to market and when to invest in more capacity, and through this interaction across time and place, fuel portfolios become more certain and prices become more stable. Government removal of obstacles to this vital transmission of information through market processes is the most productive and constructive action that governments can take in the face of this impending "natural gas crisis".

SOME NATURAL GAS ARTICLES: This Detroit Free Press article illustrates how typical families both feel the effects of higher natural gas prices and use contracting options (such as the "budget plan" that smooths their bill out over the year) to mitigate those effects.

Basic industries, such as fertilizer and ammonia makers, that use gas to produce their goods are already laying off workers. And experts warn that a warming trend -- in the economy or the weather -- could cause a spike in prices for the electricity that cools homes and runs every sort of business.

"You would have thought that the last big upsurge in prices a couple of years ago was a tremendous wake-up call," said Gwyn Morgan, chief executive of EnCana Corp., a Canadian company that is North America's largest independent natural gas producer. "But for most people it was not."

The market manipulation by companies such as Enron has gotten much of the blame for the price surge of 2000 and 2001. But now -- like then, most analysts agree -- the basic law of supply and demand is at work.

With natural gas promoted as a cleaner-burning fuel than oil or coal, nearly all of the electric plants built since 1998 are designed to be fired mainly by gas. So demand is up. Although drilling has increased about 25 percent in the past year, much of it has been confined to old, overworked basins that are not as productive as they once were. So supplies have not kept up.

The fertilizer industry has been particularly hard hit, since natural gas accounts for 90 percent of the cost of ammonia, the building block for nitrogen fertilizers. Robert C. Liuzzi, chief executive of CF Industries, a farm-supply cooperative based in Long Grove, Ill., said high natural gas prices were the most serious threat to the industry since the energy shocks of the 1970's.

Ammonia manufacturers are not faring any better, with factory closings becoming common. Mississippi Chemical, an ammonia company based in Yazoo City, Miss., filed for bankruptcy protection last month. The company idled a plant in Ohio, cut production at another in Tennessee and shut down a factory in Donaldsville, La., resulting in the loss of 24 jobs. ...

Power generators that are capable of switching their plants to fuels like oil or coal are doing so to mitigate their dependence on gas. But analysts say that this, in turn, is contributing to higher prices for those fuels.

Over all, about 23 percent of the nation's energy needs are met by natural gas. The United States is a large producer of natural gas, second to Russia, and 85 percent of the gas used here comes from domestic wells. But many parts of the country remain off-limits for drilling for environmental reasons.

This article is really good; I recommend that you read the whole thing if you want a quick overall picture of the issues in natural gas markets.

Price increases serve as the most effective inducement to conservation, because they signal to consumers large and small that the relative value of natural gas has increased. If they value it sufficiently, they'll suck it up and deal with the price increase. If they don't, or can't, then they conserve.

"Can't" there reminds me: the Low Income Home Energy Assistance Program (LIHEAP) is a federally-funded energy bill subsidy for low-income households. So there is a "safety net" for low income families who face higher bills. I'm not convinced that it is administered or marketed in a way to ensure that eligible families get the most bang for the buck out of it, but it's in the existing regulatory toolkit.

In any case, I hope this growing concern over natural gas will produce a constructive, thorough conversation about the interaction of various fuel and environmental decisions, as well as how best to induce conservation and investment. It's an overdue conversation.

There's a large field in new institutional economics that explores precisely this dynamic. It builds on the ideas in Coase's seminal article "The Theory of the Firm," in which Coase analyzes how transaction costs determine what transactions take place in markets and what transactions take place internally, in firms. The move away from vertical integration is an indication that transacting through markets has gotten easier. Firms still exist for several reasons, explored in related literature stemming from Oliver Williamson's pioneering work, including ex post vs. ex ante monitoring costs, contracting costs, and access to capital markets.

In fact, my main summer research project is precisely in this vein. How did the reformulated gasoline requirements of the Clean Air Act amendments of 1990, and subsequent state-level boutique fuel regulations, affect refining transactions? Did they induce more vertical integration, or less? Did wholesale refiners merge with companies in other parts of the value chain? And what did these regulations do to refining costs?

In an environment in which fuel regulations balkanize markets, fuel in one place is no longer substitutable for fuel in another. That balkanization re-introduces price disparities that competition naturally diminishes through opportunistic arbitrage, and because it is the consequence of the application of blunt, inflexible regulatory instruments, the natural diminution of price disparities is cut off at the knees. Thus wholesale fuel markets become less resilient and less able to absorb unanticipated shocks such as pipeline mishaps, fires, etc.

We have this problem in Illinois too. At least for us, though, the ethanol is just downstate, so the transport costs aren't so obscene. That doesn't make it right, though.

While I'm in DC-politics-land, let me also draw your attention to what I find a very robust vision statement for our energy future. It comes from Senator Jon Kyl (R-AZ), and took place during floor debate on S.14 last week. If you want to read the context of my excerpt, scroll down/search for the bottom of page S7706 in the Congressional Record.

This bill subsidizes two types of energy. That which few consumers would be willing to pay for and that which companies would produce and consumers would pay for in the absence of subsidies. I ask my colleagues if this makes any sense?

Let's let the competitive market determine our energy future. Let's let the market, with millions of individual consumers pursuing their individual energy needs, based on their own unique situations, steer this country's energy economy. Let us not dictate to consumers and taxpayers how they should spend their energy dollars. ...

Let me suggest that the greatest obstacle to affordable and reliable energy in this country is the U.S. Government. Before this body looks outward for solutions to our energy problems, it should look inward. It should identify those laws, regulations, and other Government impediments that prevents this country's citizens and businesses from making sound energy decisions. We encumber the U.S. energy economy with all sorts of onerous and often unneeded and outmoded rules that raise the cost of energy and distort energy markets. Instead of fixing this state of affairs, this bill compounds these errors by further raising the cost of energy to American taxpayers and further distorting energy markets through subsidies.

DISCLAIMER: I do not necessarily agree with the contents of these commentaries; in particular, I think Titles VIII and IX (on hydrogen and on R&D) will have particularly distortionary consequences and leave us with a less resilient economy than we would otherwise have. Obviously the Senate Republican Conference is not going to say that! And on ANWR, I would actually argue that we should privatize federal lands, so these sorts of decisions would be made with less political motivation. Analytically speaking, the amount of oil in ANWR is a drop in the bathtub, but if the residents, naturalists, and oil companies can achieve a mutually beneficial expectation of a value proposition, who am I (or who are you folks in Congress) to stop them?

Then yesterday the federal government announces that they will pursue their hydrogen partnership with the EU. This Washington Post story and this AP story build off of a speech that Secretary Spencer Abraham gave at a hydrogen conference in Brussels (but which is not yet available at energy.gov). According to the AP story:

Whether hydrogen is produced from nuclear reactors or from coal-burning power plants, "we intend that all our hydrogen eventually be produced using emissions-free technologies," said Abraham. In one program to make hydrogen, he cited as an example, the Energy Department wants to pursue a $1 billion program to build a pollution-free coal burning power plant where carbon dioxide and other emissions would be captured.

Clearly, some very prudent short-term steps emphasizing conservation are needed. In the long term, however, the nation must have a serious debate on energy sources and supply, with all types of energy - coal, oil, gas, nuclear, solar, wind, and others - on the table.

The sooner we start thinking about our energy strategies using portfolio diversification, the more stable and less volatile both supplies and prices will be. I would add to their list that we have to have a serious debate over the role of open, free electricity markets in providing that short-term conservation, which will lead to lower fuel use and less infrastructure investment, through an active demand side.

MORE ON NATURAL GAS ECONOMICS AND POLITICS: A good article from Oil & Gas Journal on the natural gas supply concerns in the U.S., highlighting in particular Alan Greenspan's remarks on the matter on Wednesday. The article does a nice job of pointing out the political dimensions of this essentially economic issue. I especially like Greenspan's understanding of the benefits of integrated global energy markets, not focusing on balkanized domestic production when it can be done more cheaply elsewhere:

But, Greenspan rejected assertions by Tauzin and other lawmakers, including Rep. Joe Barton (R-Tex.), that the US needs to boost domestic production to stabilize prices and reduce reliance on potentially unstable foreign energy suppliers.

"If North American natural gas markets are to function with the flexibility exhibited by oil, unlimited access to the vast world reserves of gas is required," Greenspan said during his testimony.

Later in an exchange with Barton, Greenspan said the US is "committed irrevocably to globalization for a good reason," and that "it is in the interest of the country not to be protectionist. We don't have a choice."

This Christian Science Monitor article also provides a good analysis of the issues involved in the natural gas markets, and in the political debates over the House and Senate versions of the energy bill.

And this New York Times article highlights the conflicts over offshore drilling for oil and natural gas, and even over doing the exploratory inventory work to see what deposits there are and how difficult and/or expensive it would be to extract them. Again the old-style environmentalist voices in this debate (as illustrated in this article by Bob Graham and Barbara Boxer) see this exploration as the first chink in the armor, and that it will inevitably lead to the destruction of all of the offshore drilling bans that have been in place for almost a quarter of a century.

In debating the Senate energy bill S.14, the Senate has voted to approve such an exploratory inventory. This provision would enable the Department of the Interior to survey coastal areas to determine the reserves of both oil and natural gas, and the feasibility and expense of extracting them. Such knowledge is a good input into making informed decisions about whether or not it's worth incurring some environmental disamenities to achieve the added benefits from increased domestic fuel supplies.

THE NATURAL GAS "CRISIS": Where to start ... those of us who pay attention to energy have seen dwindling natural gas supplies over the past year, but now they seem all the more pressing, so the politicians are getting all in a tizzy and wanting analyses of what, quite simply, is another example of the interaction of regulatory policy, supply, and demand. Reductions in domestic supply due to decreased land that is legally available to drill, in conjunction with the expectation of future import decreases from places like Canada if they follow through with Kyoto, have increased supply concerns for the near and far future. And demand increases as more electricity is generated from natural gas to comply with environmental regulations. Thus decreased supply and expectations of decreased future supply meets increased demand and expectations of increased future demand => higher average prices, and increases in price volatility. No mystery, no conspiracy.

Lost in all these political machinations is the decisive scientific evidence that ethanol doesn't perform as advertised. Both the Environmental Protection Agency and the National Academy of Sciences have issued reports showing that adding ethanol to gasoline will at best have no effect on air quality and could even make it worse. Studies show ethanol could even increase emissions of nitrogen oxides and volatile organic compounds, which are major ingredients of smog.

What's more, adding ethanol costs about five cents extra per gallon and will reduce fuel economy by about 3 percent, for an effective cost increase of 10 cents per gallon. For the average family of four this will amount to about $180 per year - say goodbye to a nice chunk of your tax cut. And if ethanol demand outstrips supply, as many energy analysts predict, motorists could suffer much bigger price increases, as much as 50 cents a gallon according to some estimates.

That's a pretty accurate description of what occurred this spring in California with the switchover from MTBE to ethanol as a fuel oxygenate.

Mandating fuel efficiency improvements will impose net costs on motorists. About 70% of the benefits claimed for fuel efficiency improvements are direct benefits to motorists in the form of savings in gasoline costs. But motorists can already purchase any of a few dozen vehicle models that get more than 30 miles per gallon (mpg), and yet, on average, they choose vehicles that get a bit more than 20 miles per gallon. Motorists are aware of the level and volatility of gasoline prices and no doubt take this into account in their purchase decisions. This suggests that whatever costs and benefits the Report counts in its cost-benefit analysis, they have little to do with motorists’ actual valuation of greater fuel economy vis-à-vis other automobile amenities. When automakers can offer high-mileage vehicles with a palatable combination of price and other desired amenities, motorists will choose them without any external prodding. This suggests that mandating fuel efficiency increases will impose net costs on Americans. Therefore, rather than benefiting Californians, implementing the Report’s recommendations would likely make people worse off.

Reducing petroleum consumption would not reduce oil security costs. The level of U.S. expenditures to protect middle east oil supplies is a matter of debate in the research literature. But whatever the costs are, marginal reductions in petroleum use won’t reduce these costs. The level of military effort that policymakers judge to be necessary to protect the oil supply and meet other U.S. geopolitical interests is likely to be independent of oil consumption over a wide range of oil consumption levels. A 15% reduction in California or even U.S. oil consumption would probably have no effect on such decisions. The estimated benefits due to decreased oil security costs should be removed from the Report’s cost benefit analysis.

Implementing the Report’s recommendations would worsen future air quality. Existing CARB LEV II requirements will eliminate more than 90% of current vehicle emissions during the next 20 years or so, leaving little marginal benefit to be had through additional measures. Yet by making new cars more expensive, implementing the Report’s recommendations will slow the rate of new-car purchases, which would in turn slow progress on air pollution by slowing vehicle-fleet turnover.

Internalizing the environmental cost of CO2 emissions would not change motorist behavior. The Report estimates the harm from CO2 emissions to be $15/ton, which is equivalent to about 15 ¢/gallon. These costs could be internalized through a gasoline tax, but such a tax is probably too small to change motorists driving behavior or vehicle-purchase decisions. If internalizing the cost of CO2 emissions wouldn’t appreciably change motorists’ behavior, then requiring CO2 reductions is almost guaranteed to impose net costs on society.

The Report assumes a static petroleum market. The Report assumes no changes in the petroleum market between now and 2030. But the petroleum market is dynamic. New oil development in Russia, the Caspian Sea, and West Africa, along with ongoing reductions in oil exploration and recovery costs, are reducing OPEC’s ability to control petroleum supplies. These trends will tend to reduce both the future cost and volatility of petroleum.

The Report ignores government-mandated balkanization of fuel markets as a source of gasoline-price volatility. Some and perhaps much of the volatility in gasoline prices is due to regulatory requirements on fuel composition that vary from place to place. Despite this factor being under the complete control of state and federal policymakers, the Report does not address reforming reformulated-fuel requirements as a means of reducing price volatility.

Importing gasoline from out-of-state refineries is not a problem. The Report notes that California doesn’t have enough in-state refining capacity to meet its future fuel needs and dubs this a problem. This is no more a problem than the fact that Los Angeles is a net importer of food. Gasoline producers will efficiently respond to consumer demand if allowed to do so.

CALIFORNIA GASOLINE PRICES ARE HIGH FOR GOOD REASON: According to this preliminary Energy Information Administration report on California gasoline prices. I really want to paste in an excerpt here, but they've set Acrobat so I can't copy text (grrr), so here's the punch line: after you take out last year's crude oil price spike, these factors conspired to raise gasoline prices:

-refineries producing close to physical capacity
-isolation and distance from other sources, such as Gulf Coast refineries
-California-specific gasoline, mandated to address air quality issues, which fragments and balkanizes wholesale gasoline markets
-the switch from MTBE to ethanol as the oxygenate

In other words, policy decisions and not price gouging are the fundamental root of higher and more volatile gasoline prices in California.

Kevin Brancato has a nice post on a new US-Chile trade treaty. Freer trade, a win-win proposition! Kevin's also right to express skepticism about "competition policy", which does leave a foot in the door for political corruption.

In general, the more the state intervenes in an economy, the worse that economy performs. Statists argue that this is irrelevant because the market produces some spectacular failures. Indeed it does. But arguing that we should fix it by turning to the State is like arguing that, because modern cancer therapy often fails, we should put a witch doctor in charge of treatment instead of an oncologist.

MORE ON ETHANOL: This Washington Post article from last week discusses the extent to which ethanol production and its increase will be a part of the Senate energy bill proposal, on which the Senate springs back into action this week. How has ethanol become so deeply embedded in federal energy policy, even though it's expensive, hard to transport, and creates a net energy deficit (i.e., it takes more energy to produce it than it produces itself)? This quote from the story gives a hint:

To ensure victory, the ethanol industry has created a potent combine of interest groups over the past year, ranging from the farm belt to major oil and automobile companies, the highway lobby and the American Lung Association. The method was pure horse trading, participants say. "Everybody in the coalition needed to see some benefits," said Robert Dinneen, president of the Renewable Fuels Association, ethanol's lead lobbyist in Washington. Farm communities, energy consumers and the environment all benefit as a result, he says.

BUT ... and this is the part that no policymaker wants to confront ... at what cost?

Here then is the situation of the mind, as I have already describ'd it. It has certain organs naturally fitted to produce a passion; that passion, when produc'd, naturally turns the view to a certain object. Shall we explore how our passions fulfill the double relation of impressions and ideas?

As befitting the inspiration, an offer replete with passion, intellect, rationality, and empirical exploration.